News and opinions tailored to the interests of the community of early stage investors.

Thursday, July 25, 2013

As the SEC Creates New Hoops for Angels to Jump Through, ACA President Verrill Objects. Are Techstars, GUST at Risk?

“With the recent rules put forward by the SEC on
General Solicitation, there could well be some negative affect on our usual way
of doing business. Would you provide your tax returns to a CEO in order
to invest in his/her company? Or would you pay a third party to do so,
and have them verify that every three months, “ asks Angel Capital Association President David Verrill in a note to us today.

The ACA is very aggressively pushing the SEC
to better understand how startups get funded, and the normal process that we
use to generate deal flow, share deals, and the time, effort, mentorship,
judging etc that we contribute to the ecosystem. We shouldn't be burdened
with additional hoops to jump through, nor should our CEOs. Toward that
end, the WSJ today printed an OpEd piece on the subject - I am the author, but
certainly many colleagues in the ACA contributed to it. We can all do
ourselves a service by becoming knowledgeable of these issues, and sounding the
alarm to our members and the broader ecosystem so that these rules do not
become permanent after this 60-day public review period.

Below is a blog that will soon be posted on the ACA
site that sheds a little more light. I may well circle back to each of
you in the coming weeks with a call to action letter writing campaign.

Why is the ACA Making a Big Deal about the SEC
Ruling on General Solicitation?

Last week's SEC ruling on General Solicitation
sounds an alarm to angel investors in the US on several grounds. But first, a
quick summary of the ruling. Rule 506b keeps regulations as they are for those
companies who only privately solicit funds from self-certified qualified
investors. No harm there, and thanks to the SEC for maintaining the status quo
for what has been historically the best way for startups to raise money from
accredited angel investors.

The problem is with the new 506c rule, which puts
the issuer (CEO of a startup, hedge fund manager, venture capitalist) on the
hook to take “reasonable steps” above and beyond the self-certification
questionnaire to verify accreditation of an investor if the issuer generally
solicits that investor. The definition of what constitutes being generally
solicited is extremely broad, including anything public, such as an event or
appearing on a Web site. Herein lies rub #1. Much of the deal flow for my
angel group comes from events and activities that could well be considered a
"public" forum. Think about the accelerators (TechStars Demo Day),
business plan contests (MIT $100k, MassChallenge events), or even the portals
(Gust) that all have mechanisms of communicating with their various audiences
that makes them likely subject to the 506c requirements.

These critical
members of the startup ecosystem are very important sources of quality deal
flow for angels (and VCs) - and they are activities that we all volunteer,
mentor and judge in. In order to avoid any question of whether or not 506
b or c would apply, an issuer might play it safe and file under 506c because
the penalties are severe (like offering your investors their money back, or
being banned from raising more capital for a year) if you file for 506b but are
shown to have generally solicited. What would you do as a startup
CEO?

For 506c filings the SEC provided a complicated set
of principles about what constitutes “reasonable steps”, although it did
provide a non-exclusive list of methods that would satisfy the requirement,
such as two years of federal tax documents to the issuer – or, have a third
party (lawyer, accountant, broker, investment advisor) verify accreditation,
and re-certify on a regular basis (as frequently as every 3 months).
Herein lies rub #2. Angels invest their own money, when and where they
want. We avoid brokers, and have no investment advisor intermediaries – we know
the startup space better than any investment advisor. The dozen or so
angels I talked with this week said they would never give their tax returns to
a startup CEO, broker, lawyer or investment advisor. While providing more
detailed financial information for an investment in say, a hedge fund, is
common practice and perceived as a cost of doing business (and some would argue
for good reason given the fraud in that particular asset class), this is
certainly NOT common practice in angel investing – we don’t need them, don’t
want to pay for them, and don’t want to introduce unnecessary third parties
into an ecosystem where there is virtually no fraud. We want every penny
going to the startup – not some unnecessary third party.

The US General Accounting Office (GAO) has
been given the responsibility by Congress to review the rules of
accreditation. Today you are considered a sophisticated and accredited
investor if your annual income for the past two years has been $200,000 or more
(or $300,000 if filing jointly with your spouse), or your net worth is more
than $1 million (not including your primary residence). Last week the GAO
thankfully did not recommend increasing these hurdles – investors like the
consistency of regulation; if the hurdles were increased significantly
then huge numbers of angels would stop investing. The GAO did not do
angels any favors though in recommending the SEC consider adding additional
criteria to the wealth and income levels –like the use of investment
advisors. Will an investment advisor provide any value added to the
270,000 active angel investors in the US?

The SEC (and GAO) has done a great job of soliciting
inquiries from organizations and individuals far and wide. But frankly,
they have not paid attention to how the startup ecosystem works, and who the
drivers are. In 2012 angels are estimated to have invested nearly $23
billion in more than 67,000 startup companies – constituting almost 90% of the
outside capital to get those companies started. That is 20 times the
number of companies that VCs invested their $27 billion in last year, with very
little of that going to true startups. The startup companies that angels
funded last year created nearly 275,000 jobs – and over the last 20 years
companies less than five years old have provided nearly all of the net new jobs
in the United States. Hedge funds raised more than a trillion dollars in
2012 - a huge part of the alternative investment economy to be sure, but did
they create any jobs?

Angels are the lifeblood of startup companies in the
US. Angels invest on every Main Street in the US, not just Wall
Street. Angels are primary job creators in our economy. Angels
provide expertise, mentorship and a whole host of other benefits besides their
money. Angels tend to plow profits back into the startup ecosystem.
Angels invest their own money, not those of a pension fund. There is
almost no fraud in the angel world.

The SEC needs to recognize the power of angels, and
the value chain of funding a company from startup to successful exit. The
SEC needs to protect angels with safe harbors against 506c. The SEC needs
to continue preserving the self-certification of accreditation in 506b.
And the SEC needs to maintain the current levels of income and wealth for
accreditation without onerous and unnecessary requirements – including third
parties. Only these actions will allow the Jumpstart Our Business
Startups (JOBS) Act to achieve its intended goals – to make it easier for
companies to gain funding, and create more high paying jobs.

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About Me

George McQuilken is a founding member of the eCoast Angels Network, a group of private investors backing early-stage companies.

McQuilken was founding CEO of four companies including RSA Security. As Editor of the IBM Systems Journal, he published many of the seminal papers on software management, measurement, security, and quality. He was a project leader at IBM’s Cambridge Scientific Center working on virtual machines and networking. He is a graduate of MIT and member of the IEEE and the ACM.